Sept. 22
(BusinessDesk) - Fonterra Cooperative Group chief executive
Theo Spierings says legislation will mean drastic changes in
the Chinese infant formula market with the removal of
between 1800 and 2000 brands in the next 15 to 18
months.

Regulatory changes require each entity to have
only three brands and three different recipes of infant
formula in a bid to crack down on the grey market and allay
consumers’ food safety concerns by reducing fake
formula.

Spierings said Fonterra was well-positioned in
every segment in China where it is already the global market
leader for ingredients such as whole milk powder but a lot
of things have changed in the past few years including a
shift to sales from mother and baby shops to
e-commerce.

The dairy cooperative, which has raised its
forecast milk payout twice in as many months, posted a 65
percent gain in full-year profit as cost-cutting and cheaper
milk made up for a revenue decline.

Profit rose to $834
million in the 12 months ended July 31, from $506 a year
earlier while revenue fell 9 percent to $17.9 billion. The
overall result shows a big swing towards more value-add
which saw its return on capital rise to 12.4 percent from
8.9 percent the previous year.

“Our strategy is about
ensuring we do everything we can to minimise the volatility
in earnings but it's not going to go away,” said chairman
John Wilson. “There is no doubt to some extent
profitability is positive because dairy prices are lower but
you’ve seen us announce for next year a lift in our
earnings forecast as milk prices are coming up.”

This
week Fonterra raised its forecast payout for the current
season by 50 cents/kgMS to $5.25/kgMS, for a total payout of
$5.75-to-$5.85 including forecast earnings of 50 to 60 cents
available for distribution.

Greater China, Fonterra’s
key market, produced earnings before net finance costs and
tax of $64 million through its China farm division, which
includes two farming hubs, increased annual losses to $59
million, up from $44 million, due to weak global milk prices
during the year.

There was a recovery in Chinese demand
with dairy imports up 27 percent this year and Fonterra had
48 percent volume growth to 1 billion litres in its consumer
and food service business there, which is continuing to
expand in mainland China, Hong Kong and Taiwan.

Milk
production from its 10 China farms hit 230 million litres
and a third farming hub is now being developed under a joint
venture with Abbott Laboratories, which will use some of the
milk produced.

Wilson said the cooperative was
satisfied with that level of farm development at this stage
having revised its original intention to produce one billion
litres of milk out of China.

“With these two hubs we
will be producing between 300 and 400 million litres and
we’re very comfortable with that which is at a critical
mass that we can now make the right decision on what do with
that fresh milk into our consumer and food service brands
and products and key Chinese customers’ local
businesses,” Wilson said. “We will make those decisions
in coming months, rather than years, on what do with
that.”

Integrating the Chinese fresh milk, currently
sold on the spot market, into its other operations in China
won’t necessarily mean Fonterra building a processing
factory in that country as Wilson said it could be done by
third-party manufacturers instead.

“The Chinese market
is evolving so rapidly. That’s why ingredients out of New
Zealand are so important and any manufacturing in China will
be supplementing ingredients from New Zealand with a fresh
dairy offering from China and we need both as that market
evolves, particularly down the east coast of China,” he
said.

Spierings said currently 100 percent of the milk
used for its products in China is produced from New Zealand
but over time he could see that shifting to 80 percent from
New Zealand and 20 percent from its Chinese farms.

There
were plenty of questions at today's results briefing on
Fonterra's $747 million investment last year in Chinese
infant formula maker Beingmate which warned investors it was
anticipating a first-half loss of up to 230 million yuan.
Its share price has dropped from the 18 yuan a share that
Fonterra paid for its 18.8 percent stake to 11.67 yuan. The
tie-up includes a distribution deal for Fonterra's Anmum
infant formula brand.

This week Fonterra also got
Australian and Chinese government approval for its joint
venture with Beingmate to purchase Fonterra’s infant
formula plant at Darnum in Australia, which Wilson said will
mean product destined for Beingmate’s Chinese customer
will now start rolling off the production line.

The Darnum
joint venture is a key component of Fonterra’s partnership
with Beingmate to create a fully integrated global supply
chain from the farmgate direct to Chinese consumers using
Fonterra’s milk pools and manufacturing sites.

Wilson
said the Beingmate investment was part of a wider strategy
in China that was now starting to come together.

“We’d
like to see the Chinese infant formula business be far more
in balance and we anticipate that happening in the next 12
months,” he said.

For the overall business, around 4000
“transformation” initiatives delivered $2.2 billion in
free cash flow, of which $1.6 billion was used to reduce its
debt to $5.5 billion, lowering its debt gearing ratio to
44.3 percent from a record high 49 percent the previous
year.

Wilson said the debt gearing would have fallen to 42
percent if it hadn’t used the strength of its balance
sheet to support its farmer shareholders through tough times
after two years of low payouts, by advancing payments and a
support loan.

“We have used the strength of the co-op
paying down that debt to get cash flow flowing through to
our farmers and still delivered a strong balance sheet for
the co-op," he said. "That’s the important thing, getting
the balance right.”

Fonterra also turned around its
loss-making Australian operations, delivering a $63 million
earnings before interest and taxation compared to a $92
million loss last year after what Spierings said was “big
changes in milk prices which were not connected to what was
being earned in
market”.

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